An Overview Of Short Selling

The vast majority of investing consists of buying, or going long on a security with the intention of seeing it rise in price, after which it can be sold for a profit. A more specialized strategy is to do just the opposite, or sell a security "short" with the intent to have it fall in price so that it can be bought back later at a lower price.

National BansShort selling is a less common strategy, but is subject to much more controversy. During the credit crisis, a number of European countries banned the bearish strategy in financial stocks because they thought it was contributing to market volatility. They also speculated that traders' collective use of the strategy helped drive the market down to extremely depressed levels at the height of the crisis. In 2011, South Korea banned short selling after it hit a record high among foreign investors. The United States held off on any outright bans on the practice, though it was also considering it and may do so again during periods of outright market panic.

Legal Issues and UsesMany companies also don't take kindly to any short selling activity for their underlying shares. The management of online retailer Overstock.com has taken a number of Wall Street firms to court, alleging they worked with underlying broker clients to drive its share price down. However, despite some company's abhorrence of short-selling, overall it does serve a number of useful purposes in the market.

Short selling provides investors with an invaluable tool to profit from a company that is seeing its business fundamentals deteriorate, or target management teams that are proving ineffective or even incompetent. Along with shareholder activism, it helps keep companies on their toes and also allows investors an opportunity to hedge, or protect positions from bear markets, such as what occurred in late 2008 and early 2009.

However, like most investing, short selling can be abused. In the Overstock litigation, a number of the brokerage firms under fire agreed to undisclosed settlements with Overstock, which could suggest they were simply interested in putting the matter behind them but it also indicates that potential market abuses were occurring. A couple of others continued to defend themselves in court, with Overstock appealing a court decision to throw out the remaining complaints.

The Naked ShortNaked short selling is also illegal. To undertake in a short position, an investor, or the underlying broker, must ensure that shares of the stock are first available so that they can be borrowed and then sold short. It has been determined that a sufficient number of unethical market participants have manipulated the market by "nakedly" shorting shares that weren't available to be shorted. This could indeed unfairly drive a share price down.

The Bottom LineFor the most part, short selling has a bad reputation despite its advantages to the individual investor. Market participants, such as the underlying investors and market facilitators, engage in a practice that allows them to hedge their bets in the event that a company fails to perform. For this reason, outright bans on short selling end up harming the overall market and market efficiency. Of course, checks should be in place to bring market manipulators to justice, though just like in the market overall, it can be difficult to separate a few bad apples from the good ones.